Are Airlines the New Railroads?

There is a joke that has circulated for some time that goes something like this: How do you become a millionaire? Be a billionaire and start an airline.

For decades, the airline industry was incapable of producing strong profitability. In the few periods when they did earn positive amounts of net income, a looming recession or business cycle downturn would more than wipe out the prior period’s good results. Airlines had been synonymous with cyclicality, capital intensity, low barriers to entry, and poor investments.

There are signs that United States based airlines are leaving their past behind. One notable sign of that is the recent endorsement of Warren Buffett, the legendary investor, who had stated in the past:

The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.

Nevertheless, Buffett has changed his mind about the industry and invested substantial amounts of money in the common stock of several airlines. According to the 2016 Berkshire Hathaway Annual Report and other SEC filings, his holding company now owns 7.5% of Delta Airlines, 7.0% of Southwest Airlines, 8.4% of United Continental, and 9.3% of American Airlines. Altogether, these stakes are worth about $9 billion, or 7% of Berkshire’s $122 billion common stock portfolio.

What changed in Buffett’s mind to alter his perspective so dramatically? The investment that was made is very similar to Buffett’s earlier investment in railroads. In 2007, after years of showing no attraction to railroads, Berkshire reported investing $6.5 billion in the sector. The bulk of that investment went to buying the common stock of Burlington Northern Santa Fe, which Berkshire would later buy outright.

Railroads had been tightly regulated for a very long time in the United States, as had all forms of transportation. Following deregulation in the late-1970s, railroads needed time to adjust new realities and rationalize the number of companies in the sector. Today, there are only four major US railroads: BNSF, Union Pacific, CSX, and Norfolk Southern.

Between 1998 and 2016, these railroads were able to collectively reduce their operating ratio (the inverse of operating margin) from almost 90 to about 65 – a dramatic improvement. And this occurred while revenues continued expanding.

Are airlines now at a similar inflection point? It would seem that the competitive position for airlines is not quite as strong as that of railroads for the simple fact that barriers to entry remain lower in the airline sector and regional airlines continue to proliferate. But, at the same time all of the major US airlines have acquired rivals in recent years and reduced the number of competitors in the sector.

Northwest Airlines was acquired by Delta in 2009; Continental by United in 2010; AirTran by Southwest in 2010; and US Airways – itself previously merged with America West – was merged with American in 2014.

Revenues (in $,000s) for major US airlines, 2000-2016.

Approximate market shares of major US airlines.

This has caused the market share of the large, legacy carriers in a much more enviable position. Among the airlines surveyed above, Delta controls about 26% of the market, United 24%, Southwest 14%, and American 27%.

This increased market power has translated into substantially stronger financial performance:

Operating margin of individual US airlines.

The last two years have seen gushers of cash that the industry has never before been accustomed to.

Of course, the other piece of the puzzle in ascertaining airlines new-found attractiveness is their current valuations – suggesting investors have not yet fully believed in the sustainability of the improved performance.

With airlines currently trading at 10x earnings and railroads at 20x earnings, the margin of safety is clearly greater in the airline sector.

Will Berkshire purchase an airline in the same manner that it purchased a railroad? Maybe and maybe not. The BNSF purchase came in the midst of the Great Recession, so when the next recession comes and airline stocks predictably fall, look out for a potential bid but probably not before that time.